International Evidence on Market Linkages after the 2008 Stock Market Crash

Article excerpt

ABSTRACT

The 2008 crash was the most important global stock market crash in history since the Great Depression. In this paper, we study the contemporaneous co-movements of and the time-series lead/lag linkages between global stock markets after the 2008 stock market crash by using the time-varying correlation analysis, principal components analysis (PCA), and Granger-causality (G-C) statistical techniques. We find that correlation between global stock markets has increased and the benefit of global portfolio diversification has decreased since the 2008 stock market crash. The PCA technique can group global stock markets in terms of the similarities in their contemporaneous movements. Global investors can maximize the portfolio diversification benefit by investing in stock markets with high factor loadings in different principal components. Our PCA results indicate that all Asian stock markets, except the Japanese stock market, are lumped together in one principal component and the stock markets in the rest of the world are lumped together in another principal component. Our G-C test results show that the U.S. stock market has substantial influence on the European and Australasian stock markets. U.S. stock returns lead the European and Australasian stock returns (i.e., the past returns of the U.S. stock market can predict the future returns of the European and Australasian stock markets).

World economies had a serious financial crisis in 2008. During the October 8, 2007-March 9, 2009 period, major global stock markets experienced the worst crash in history since the Great Depression. The U.S. stock market fell by about 56 percent during this period. All other major stock markets worldwide experienced similar tailspin.

The stock market crash of 2007-2009, as measured by American markets, began on October 9, 2007 when markets hit their all time highs and concluded on March 9, 2009 when markets bottomed (Wikipedia, 2011). While this financial crisis began in the USA in the fall of 2007, it spread globally within six months. Foreign governments and investors became victims of the globalization of financial markets. Global stock markets in the developed and emerging economies plummeted, reporting worse losses than experienced in decades. The resultant economic uncertainty froze credit, caused large financial institutions to collapse, and major businesses to fail. Foreign direct investment fell substantially as well. Unemployment grew significantly. Between 2007-2008, the Global Stock Market losses totaled $21trillion worldwide (Thompson, 2009).

As the markets began to improve (2009-2010), a recovery pattern emerged: developed economies were hit harder and took longer to rebound, on average, than developing and emerging markets. The S&P BMI index for Developed Markets showed a -7.3% annualized return from 2007-2009 as compared to a +4.2% rise in stock market values for Emerging Markets during the same period. Developing and emerging markets had more conservative fiscal policies, and their financial institutions and monetary policies were less integrated with the developed financial markets. "By the time the big crisis in wealthy nations struck, emerging economies were far less vulnerable than many advanced economies. In the panicky months after the fall of Lehman past prudence was not enough to insulate countries from global recession. But once the free fall ended, the emerging world staged a strong recovery, even as advanced economies struggled" (Krugman, 201 1).

Table 1 provides evidence that emerging markets rebounded faster and stronger than markets in developed economies. Comparing the October 2007-January 2009 period with the first six months of 2009, the U. …